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Wealth Management: Strategy blog – Suprasecularly speaking…

Strategy team - Kevin Gardiner (Wealth Management)

We like to think we take a long view, but alongside the investment horizon implicit in a recent Bank of England Working Paper we might have the attention span of a gnat.

The figures in the title of Paul Schmelzing's Eight centuries of global real interest rates, R-G, and the 'suprasecular' decline, 1311-2018 don't refer to trading hours, but to years. He has compiled, for the first time, a continuous, weighted set of global real interest rate data that stretch back to the fourteenth century.

We are not worthy. Seriously: huge credit to him (no pun intended). It is a daunting feat of scholarship, and one that is receiving attention from the FT, The Economist et al.

And here's the thing. For those of us desperately seeking "normal", his data seem to suggest that it doesn't exist. Over the full period, the global real rate averages 4.6% (on top of inflation of 1.6% per annum). But even the most cursory look at his charts shows that the series is not stationary: it slopes - downwards (as, also, does the volatility of both real rates and inflation).

Starting at around 13% in the early fourteenth century (…), his identified trendline slopes down to almost zero now, at an average annual decline of 1.6 basis points (that is, 0.016 percentage points per annum).

Today's real rates of course are negative, sitting just below that trendline (and he works in terms of seven-year moving averages rather than individual years). But if we extrapolate the line into the future, it suggests that negative real interest rates will become the norm, not the exception, within many of our younger colleagues' working lives.

In other words, taken at face value, his trendline suggests that today's interest rates may not be that unusual, but merely the shape of things to come. We just got there early, maybe because of QE and LDI (liability-driven investing), expectations of secular stagnation, imminent deflation or whatever - that last point being us thinking aloud, because Schmelzing doesn't talk much about the underlying mechanics driving the trend (a point to which we shall return…).

In his work - and he makes the data available in Excel format: where were such helpful academics when we were studying? - he distinguishes between "safe" real interest rates and the overall average. It is the latter where the trend decline is most visible, suggesting that spreads for riskier loans are largely responsible (not that people noticed or thought about such things as spreads at the time).

He also suggests that a declining trend in real interest rates reflects declining returns to capital generally - and that this refutes the analysis and policy recommendations of Thomas Piketty's influential Capital in the Twenty-First Century (2014). The "R-G" in the title of his paper refers to Piketty's assertion that investment returns exceed growth rates, dooming us to higher inequality.

But this is where we say so long and thanks for all the fish.

The paper is a triumphant descriptive achievement: his detection and compilation skills, and his sheer erudition, are remarkable. But whether it is a useful guide to today's policies or investment strategies is questionable. Comparing medieval borrowing costs and inflation rates with today's may not be very meaningful.

We have known for some time that real interest rates in the distant past seem to have been a lot higher than today's. Sydney Homer's A History of Interest Rates (1902) reported Sumerian (3000 BC) real rates on grain at one-third (that is, 33 1/3 %). But ancient - and medieval - capital markets were rather different (as of course are retrospectively-constructed inflation indices).

As noted, Schmelzing does not speculate much on causality. But it is quite possible that the long-term decline in real interest rates - like the secular decline in stock market yields since stock indices were produced in the nineteenth century - is simply reflecting a massive change in liquidity and general creditworthiness.

Credit is no longer the preserve of autocratic monarchs "borrowing" from their subjects, or of individual merchants financing specific ventures, but reflects the borrowing and lending decisions of millions of agencies, households and intermediaries, all better and more quickly informed than the brightest scholars in the world were then.

Nor are we convinced that the decline in real interest rates is necessarily reflective of "the" return on capital generally (as our quotation marks suggest, we not sure that such a thing  exists, or at least, if it does, that it can easily be measured…).

History has much to teach us qualitatively - more perhaps than any other discipline - but quantitatively it can be the source of much spurious precision. The historical interest rates that are the best guide to today's investment decisions are surely those of the last half century or so - since when the downtrend has been less pronounced.

That said, as we noted in the earlier post, we're getting less, not more, confident about the prospects of monetary normalisation any time soon.

And we didn't buy Piketty's thesis anyway.   



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